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3. How Much Should Companies Focus on Earnings vs. Long-Term Growth?

Is it even correct for large-company management to focus “over the horizon?”

What role do common performance metrics play in guiding company focus and activity?

A debate that rages in the academic literature is also a constant topic of conversation in the HBS classroom: Should managers, and companies, be investing for the long-term growth of the firm, conceiving of successive generations of new organic or inorganic growth, or should they rather exploit the current core business to its fullest and let investors diversify their bets? Does it depend? And if so, on what?

Further, what clues can you discern from reported performance metrics concerning the quality of a company’s growth planning efforts? Are there any indicators you can spot that reassure you about a company’s long-term prospects? Any that should raise concern?

7 thoughts on “3. How Much Should Companies Focus on Earnings vs. Long-Term Growth?”

While there are many different considerations as to whether a management team should focus on near-term versus long-term results, one that is commonly overlooked is the impact of the cost of capital. Assumed costs of capital should be adjusted in accordance with a number of factors, but significant among these factors is the level of investment returns available across markets at any particular time, most easily described by the general level of interest rates. Furthermore, there is a plethora of analysis on company valuation methods, but simply stated, the stock price of a company is roughly equal to the value of its assets, both tangible and intangible, and the earnings those assets can generate over time. During periods of very high interest rates (high costs of capital), the net present value of near term earnings contributes proportionately less to the total net present value of the company, and conversely, during periods of low interest rates – all else equal – near term earnings are less important to overall company valuation. Therefore, a management team should invest proportionately more in long-term projects, less certain innovation, etc during low interest rate periods, as long-term earnings comprise a far greater proportion of the company’s valuation. Interestingly though, during periods of low interest rates such as the environment that exists currently, shareholders become eager for more income because of the general lack of it in this low return environment. This leads management teams to feel pressured to provide more certainty with regard to increasing dividends and/or share buybacks, as opposed to reinvesting profits into the company’s long-term projects that can generate higher net present value long-term earnings. While this is a generalized description of the current behaviors of companies, it is important for both shareholders and management teams to appreciate that their costs of capital should influence their willingness to invest in long-term projects. It is clearly in the true interests of shareholders for management to focus on creating long-term profit streams that come from near-term investments in market-creating innovations, potentially far beyond their own tenure with the company, even if these investments dampen near-term earnings.

I observe SaaS companies focusing their capital on marketing and generating cash flow. The issue probably isn’t so much balancing growth or R&D. The smart companies such as Atlassian (who do not have a salesforce) are building value because every employee is accountable for a segment of the customer journey. The must collaborate to deliver shared outcomes. They must understand their customer’s pain points as a team, and they use their own product to develop solutions.

At Stone & Chalk, our organisation is also a matrix of functions and products. As a not for profit, our success is dependent on our ability to articulate value for each “market”: Corporate Partners, Government, Startups and Industry groups. With little capital, mutually beneficial relationships underpin our reputation.

Legacy companies with complex resource structures struggle to innovate, and rely heavily on partnerships to deliver solutions that would be difficult to execute internally. This is the trend we are discovering at Stone & Chalk.

As was mentioned in the earlier incarnation of this forum, it is instructive to look at Amazon as a counterpoint to the prevailing tendency of Wall Street to favor short-term gains over long-term investment. I’m not sure how they got away with low or nonexistent earnings for so many years besides having a founder with large share holdings, but now all their investment is really starting to pay off. Amazon is poised to dominate in multiple verticals and I would not be surprised if they become the most valuable and profitable (non-SOE) company in history. I would be very eager to imbibe any insights you could distill from them.

The company I work at currently, UTC, recently spent several years and billions of dollars developing a new engine platform for Pratt & Whitney. The stock performance has been mediocre, but I wouldn’t characterize it as being punished by Wall Street. I think they did a good job on a few fronts: educating analysts on the opportunity; attracting a new investor base (it is substantially different from when this investment cycle started); and being a conglomerate that was able to largely self-fund with cash flows from other business units. So, I think this is another company worth studying to try to write a playbook for how to convince investors to be patient and allow companies to focus on their long term strategy, planning and investing for the future rather than next quarter’ earnings report.

I read a piece that GSB put out recently on the fault lines in capitalism (https://www.gsb.stanford.edu/insights/capitalism-killing-america) that spoke to this in a better way than I could articulate myself. However, in an attempt to try, the reason a company exists should be to ensure that company continues to exist and thrive. If executives are focused just on investors and increasing their own wealth (through the stocks they receive as, now the majority portion, of their compensation package) then those organizations may see gains in the short run but will be overwhelmed by the long-term game due to a focus on investments or cost reductions that increase profits often at the expense of innovation.

As discussed in the Capitalist’s Dilemma, most metrics executives are measured on are focused on improvements to a company’s present value and the ratios that investors care about rather than measures of future value and potential growth into new markets or new innovations. Beyond innovation, this also includes diversification of an organization into new areas to the point where if this continues (although Amazon is a clear exception to this–as they are diversifying in a more traditional manner) then we will never see another GE or IBM with tendrils across the entire economy.

I believe that long term growth is more realized and a classic investment strategy. I don’t believe that short term investment opportunities add value, they simply enlarge your balance sheet and increase the numbers that make analysts happy.

In other view by investing in long term opportunities you realize more and earn more from every aspect plus you have the ability to gauge your investment as the time comes by. In a short term investment opportunity the room for maneuvering it is considerably less.

Earnings vs. long term growth.

I believe that most managers sometimes fall into the trap of growth in order to boost short term earnings and please out of fear their shareholders and the analysts alike. I believe a more conservative and thoughtful approach would be long term growth.

Very famously Jamie Dimon Chairman and CEO of JP Morgan Chase has stated that he hears all the time people saying about growth, where is the growth where is the growth, well sometimes you just can’t grow. Sometimes you just need to stay put and build your balance sheet in order to be able to materialize upon opportunities that may arise in the future or keep your balance sheet tight for crisis that are near the corner.

In flying, it is critical that pilots “think ahead” of the jet and anticipate “over the horizon” threats. The same holds true for running a business or organization.

The markets a company is in are really only for today. Competitors are attacking from all sides; leaders have to anticipate these threats and develop new markets and customers. Also, your business is unique–even if it is in a mature industry. By taking the easy route and emulating the competition you make your product or service indistinguishable–and run the risk of being commoditized. Finally, leaders have to ensure the right culture and core values are instilled from top to bottom. Your culture will help your organization ride through the turbulent times and keep their perspective in good times. You cannot achieve these things by looking at the short term only.

Unfortunately, short-term pressures make long-term thinking a challenge for several reasons. First and foremost, there is a prevailing view that public corporations exist for enhancing shareholder value. If the owners of the company are not rewarded, they will vote with their feet and invest elsewhere. Closely tied to this concept is a new view of the role of shareholders. Institutional investors–with their large amounts of cash, have become more vocal in how companies are run. Another factor is the principal-agent problem. Corporate boards hire a leadership team to run the corporation and usually tie their salary to the company’s performance. Finally, the role of buy and sell side analysts has significantly risen in importance.

So how does a company address all of these concerns? With metrics. And they’re usually very short term. It seems like there’s a metric to keep everyone appraised as to the state of the company. There is a plethora of ratios to measure earnings per share, price to earnings, return on net assets, EBITDA margin, return on invested capital, and many others far beyond the scope of the time-tested DuPont Ratios.

Unfortunately, these ratios are used extensively to value corporations. Companies therefore have an incentive to plan a strategy that excels at the metrics they are being graded on. For example, Boeing lost $200m in one summer because of their push to increase their RONA without downside quality controls in place.

So what’s the answer? Perhaps there should be a re-focus on only using terms officially recognized by GAAP, eliminating “fad ratios.” Another area for improvement–while harder to implement–is to encourage mid to senior leaders to complete continuing professional education, as the US Armed Forces do. You simply cannot rely on your undergrad or post-grad degree to be your learning experience.

Finally we need to encourage vision at the top, organization in the middle, and initiative at the bottom of the ranks. Engagement–as espoused by HBS Professor Francesca Gino, leads to more disciplined, better organizations.